Rational Expectations Flashcards
State the projection theorem
What is the role of price in a Rational Expectations Equillibrium?
1) Determining an individual’s budget constraint, as in a competitive equillibrum
2) Conveying information (comes from Hayek)
What is the Grossman-Stiglitz paradox
If prices are fully revealing, information collection is has no gain
If information acquisition is also costly, it is unprofitable to gather information, hence no one will do it
This leads to the impossibility of informationally efficient markets
If there is noise, prices will not be fully revealing, typically modelled by liquidity traders
What are the welfare implications of REE?
Ex post, it is pareto optimal, but it may be in interim and ex ante pareto inefficient
Why is a REE pareto efficient?
Because it can be viewed as a competitive equilibrium in an economy with perfect information. By the first welfare theorem, it is pareto efficient
What is the No Trade Theorem?
That opening markets at the interim stage does not change the equillibrium allocation. If market are not complete, agent may trade for dynamic completeness
How does that market maker set the price in the Kyle model?
He sets the price at the expected value conditional on aggregate order flow
